High-Frequency Trading Prospers at Expense of Everyone

Dec. 26 (Bloomberg) -- Finally, a bit of evidence, rather
than anecdote, about the costs of high-frequency trading.

In a new study, Andrei Kirilenko, the chief economist at
the U.S. Commodity Futures Trading Commission, along with
researchers at Princeton University and the University of
Washington, examined high-frequency trading in a futures
contract called the e-mini S&P 500, between August 2010 and
August 2012.

The study looked at only the expiring contracts (which
trade electronically on the Chicago Mercantile Exchange) that
are used to bet on the direction of the Standard & Poor’s 500
Index. The researchers also did something they’d never been able
to do before: Use actual trading data from individual firms,
though none were identified.

What that data does is help explain the frenzy in today’s
markets: The most aggressive firms tend to earn the biggest
profits, hence the incentive to trade as quickly and as often as
possible. Furthermore, these traders make their money at the
expense of everyone else, including less-aggressive high-frequency traders.

The study found that the most hyperactive trading firms
earned an average daily profit of $395,875 in the e-mini S&P 500
contract over the two-year period. First and foremost among
those on the losing end: small retail investors. The study found
that, on average, they lost $3.49 on every contract to
aggressive high-frequency traders.

Big Puzzle

A big puzzle, though, is why these small investors lost at
all. One high-frequency trading technique is to use computer-powered algorithms to glean the investing patterns of other
traders, whether mutual funds or securities firms trading for
their own accounts. High-frequency traders can use this
information to execute profitable investments. But small
investors usually don’t have a discernible strategy. We hate to
say it, but more study is needed.

And the big question remains: Does high-frequency trading
benefit anyone beyond those who engage in it? Yes, markets
create winners and losers, but they also are supposed to
allocate capital to aid wealth creation and economic growth, not
simply serve as casinos.

It’s also unclear whether high-frequency trading lives up
to its promise of increasing market liquidity. By all
appearances, the most profitable traders actually reduced market
liquidity rather than enhanced it, according to the study.

One thing the study didn’t attempt to do is delve into the
equities market, where the biggest computer-driven trading
blowups have taken place.

Flash Crash

High-frequency trading was at the heart of the so-called
flash crash of May 2010, when the Dow Jones Industrial Average
plunged more than 1,000 points and rebounded, all in less than
an hour.

Related trading snafus have bedeviled the stock markets
since then, including the failure of electronic-trading exchange
operator BATS Global Markets Inc. to use its own system to take
its shares public, and the near collapse of Knight Capital Group
Inc., an electronic trading firm, after faulty computer software
made huge, money-losing transactions before anyone noticed.

These scenarios raise a final question: Why isn’t the
Securities and Exchange Commission, which sets the ground rules
for the stock exchanges, undertaking the same kind of study as
the CFTC? High-frequency trading probably plays an even bigger
role in the equity markets, where it accounts for more than 50
percent of the trading volume.

So far, the SEC has held hearings and taken halting steps
to develop a central repository for high-frequency-trading data
on the stock exchanges. But a functioning system is probably
years away, and even then it won’t deliver real-time information.

Understanding who wins and who loses in the equity markets
might prompt the agency to get serious. The bottom line is it
still needs to draft rules to ensure that the fastest traders on
earth don’t pile on in the event of another flash crash that
might burn us all.